Is the Bond Market the Raven?

There have been a lot of positive economic signs in recent months. Consider the following:

Two quarters in a row of 3% GDP growth

The unemployment rate has dropped to 4.1% – the lowest level since 2001

Sentiment indicators are at some of the highest levels in many years (business confidence, consumer confidence)

Stock indices are at very near all-time highs

Most prognosticators believe that some form of tax reform will pass by mid-2018, which would lower corporate tax rates, boost corporate earnings, and put more money in taxpayers’ pockets

But while all of the above seem to support the idea that the economy is picking up, recent action in the bond markets is screaming “risk off!” The chart below shows a trend that is confounding many investors and central bankers. Despite the Fed’s four 25-basis point increases in the Fed Funds rate since late 2015 and promises of more to come, longer-term interest rates remain remarkably well-contained. In fact, the spread between the yields on the 2-year Treasury and the 10-year Treasury has not been this narrow (currently 65 basis points) since 2008. This is perplexing because it contradicts the narrative of a strengthening economy. If economic growth were truly poised to accelerate, we would expect both an increase in the demand for money (loans) as well as an increase in inflation expectations – both of which would tend to push up longer-term interest rates. Instead, we continue to see scant evidence of either trend. Banks are reporting that loan growth is decelerating rather than accelerating. Inflation, at least at the consumer level where it counts, seems to have decelerated. There is also very little evidence of wage growth pressures despite what appears to be “full employment.” So even as yields on the short-end of the curve continue to rise, longer-term interest rates have been range-bound. Many market strategists view the resultant “flattening of the yield curve” as an ominous sign for the future.

Source: Bloomberg

Sources: Bureau of Labor Statistics and Bureau of Economic Analysis

The second source of concern in the bond market is the recent “spread widening” on high-yield bonds. High-yield bonds are those that are issued by companies of inferior financial standing compared to “investment-grade” bonds. As a result of their issuers’ inferior financial standing, and therefore greater risk of default, high-yield bonds offer – you guessed it – higher yields than investment-grade bonds. The way we track how much additional interest one earns on a bond is by comparing the bond’s yield to that of a Treasury bond with a similar maturity. Treasury bonds are considered to carry no credit risk (“risk-free”) because the federal government has full authority to raise taxes in order to service its debt. In any case, the difference between a bond’s yield and the yield on a Treasury bond of similar duration is referred to as the “yield spread.” Various capital-markets firms track the yield spreads on investment-grade and high-yield bonds to determine investor risk appetite for the different bond classifications.

As you can see from the chart below, spreads have been widening out on high-yield bonds over the past 3-4 weeks. Whereas investors were willing to accept just under 3 percentage points of yield premium (compared to Treasuries) just 3-4 weeks ago, they are now demanding closer to 3.5 percentage points. The widening has not been dramatic (we are only back to levels last seen in early September), but it does signal a decreasing appetite for high-yield bonds. One way to interpret the sudden change of heart is that bond investors are getting a little worried about the credit risk associated with owning high-yield bonds. And because high-yield bonds are more likely to default in a weakening economy, some investors are also interpreting that the increase in high-yield bond spreads (and therefore drop in high-yield bond prices) is a harbinger of slower economic growth ahead.

Source: Barclay’s Capital.

The tea leaves are rarely unambiguous, but they are also rarely so contradictory. The bond market is telling a starkly different story than the stock market, and it has been for a while. Does this mean the bond market is right and stock investors are delusional? Not necessarily. As I said, this dichotomy has been going on for a while now. But we should also acknowledge that the bond markets are a lot deeper and more liquid than the stock markets. As such, many investors prefer to take their cues from the former rather than the latter. At the very least, we see the action in the bond market as another reason for caution as we continue on into our ninth year of this bull market.

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